Market Spread in Crypto Trading: Complete Guide

Key Points

  • A discrepancy between the selling price and the buying price of an asset is referred to as a bid-ask spread.
  • Slippage is the difference between the price a trade was placed and the price it was executed.
  • Two factors are responsible for slippage - Liquidity and volatility
  • Typically, when an asset has high liquidity, the spread is lower. When it has low liquidity, the spread is higher.

What Is a Spread in Trading

The difference between the lowest ask offer and the highest bid offer in the order book of an exchange is known as the market spread. The gap is basically the difference between the asking price for an asset and the price another party is willing to pay for that same asset.

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To put it even more simply, picture yourself negotiating a deal to purchase Bitcoin from someone. You may say to the other individual that you would be willing to buy one Bitcoin for $5,000. In response to your offer, the other party could, however, claim that they believe it is worth more than $5,000 and is prepared to sell it for $7,000 instead.

The crypto spread, or Bitcoin Spread in this case, is the difference between your $5,000 bid to purchase Bitcoin and the other person's $7,000 ask price.

Source: capex.com

When applying this scenario to a cryptocurrency exchange, the order book effectively represents hundreds or even thousands of participants stating their willingness to purchase or sell an asset (like Bitcoin) at a particular price. The knowledge of how spreads work will not only help to understand the market depth but to avoid an often-overlooked incurred cost.

Market Spread, Things You Need to Understand

How Does the Bid-ask Spread Work?

A discrepancy between the selling price of an asset and the sum the buyer is willing to pay is referred to as a bid-ask spread. In the case of Bitcoin, it is referred to as Bitcoin Bid and ask price. Prices are determined in the exchange of cryptocurrencies, commodities, and securities by both the buyers and the sellers. The ask/asking price is the amount a seller is willing to accept for the sale of a commodity, which can be either fixed or negotiable, whereas the bid price refers to the price a buyer is willing to pay for a commodity. The bid-ask spread is the distinction between an asking price and a bid price.

Will the Bid/Ask Spread Always Be the Same?

Well, the simple answer is No. The bid/ask spread can change drastically due to market uncertainty and low liquidity. This is because buyers are often not willing to pay above a particular threshold, and sellers are not willing to sell below a certain price. Also, professional market makers, often comprising better chunk of the order book, have to adjust their bids and offers during the high volatility events for the hedging purposes.

Further, different assets have different volatility and liquidity levels, severely impacting their market spreads.

What Is Slippage?

In basic terms, slippage is the difference between the price when a trade was placed and the price it was executed. It is volatility and liquidity-induced phenomenon that can is typically represented in its percentage or dollar value.

Let’s take Polkadot, for example. If DOT was trading at $200 when you placed a buying request but due to increased demand, the order was executed at $202, the 1% or $2 change in price is the power of slippage.

Why Does Slippage Occur?

The next question to ask is, what causes the price of your purchase to be executed at a different price from the placed price? Slippage is not a price error, as it is commonly perceived by new traders. Two things are responsible for slippage - liquidity and volatility. The former has to do with the number of participants in the market, while the latter has to do with the buying and selling pressure on the asset.

Volatility

In volatile markets, price changes can occur so quickly that by the time you place your order, the price may have changed by a few points either way. As a result, the order is really completed at a different price than you anticipated.

Liquidity

Less liquid markets are subject to higher slippage due to the scarcity of willing buyers or sellers.

Source: k3no.medium.com

Factors That Determine a Spread

Trading Activity

When there is a lot of interest in a cryptocurrency, resulting in larger trading volumes, the cryptocurrency spread is usually smaller. The same cannot be said with assets that have little interest.

Liquidity

When an asset has high liquidity, there is a larger competition between buyers and sellers for their orders to get executed, hence the spread is lower. The opposite is true for the less liquid assets - lower competition between market participants results in the higher spread.

How Do We Calculate the Market Spread?

Let’s run through an example of how to calculate market spread using the ETH/USD pair on the Redot exchange.

We can see the lowest ask price for ETH was $1612.35, and the highest bid price for ETH was $1611.66. To calculate the spread, we just need to subtract the highest bid price (HBP) from the lowest ask price (LAP).

LAP - HBP = Spread

Spread = $1612.35 - $1611.66. = $0.69

If you want to calculate the spread in percentage, you will subtract the HBP from the LAP, divide the result by the LAP, then multiply by 100.

Spread percentage= (LAP-HBP / LAP) x 100

where,

  • LAP is the lowest ask price
  • HBP is the highest bid price
  • 100% to convert the result to percent

Percent Spread = (0.69 / 1612.35) x 100 = 0.043%

This is the typical way to calculate the spread on the crypto exchange. To address some other use cases though, let’s look at how to calculate variable and fixed spreads that are often employed by a crypto brokerage/middleman charging extra fees for facilitating transactions.

Variable Spread

Let’s assume a broker is receiving crypto (say Solana) from the exchange at 98.98 to 99 and adding a 1% markup to it; the amount at which it will be available to the trader is calculated from

Selling Price from Feed: 98.98

Buying Price from Feed: 99

while the price available to the customer will be calculated by the formula: (Price x Mark-up percentage).

Here, the selling price available to the customer will be:  (98.98 – (98.98 * 1%)) = 98

The buying price available to the customer will be: (99 + (99 * 1%)) = 100

Source: www.babypips.com

Fixed Spread

Unlike the variable spread, this spread width is fixed. It is formed by taking the mid-price of the market spread and then adding and subtracting half of the total customer spread to the market offer and bid price, respectively. Let’s assume the spread is fixed at 2.

Below is the example of how this is calculated on a Feed price of 1000.5 - 1001.5 the broker receives from the exchange.

Selling Feed Price: 1000.5

Buying Feed Price: 1001.5

Customer Price (Sell): (((1000.5 + 1001.5)/2) – 2/2) = 1000

Customer Price (Buy): (((1001.5 + 1001.5)/2) + 2/2) = 1002

The fee is added on top of the spread from the feed/liquidity provider and is therefore incorporated within the price that is shown to the customer.

Why Is Market Spread Important

Demand and Supply

Market spread is a reliable indicator of the supply and demand for any particular asset. Simply put, ask prices indicate supply and bid prices represent demand. Therefore, a widening of the gap usually indicates changes in supply and demand.

Profitability

When comparing the cost of transactions to the profit made from a trade, the market spread is part of the equation. Market spreads may make some trades unprofitable due to the buyers being forced to buy an asset expensively or sellers selling cheaply.

Does the Market Spread Affect Trading Strategy?

Your trading approach may perform well or poorly depending on the market spread. Many traders first only think about how the trading fees will affect their performance. Some traders will realize, after giving it some more attention, that the market spread can have a bigger impact on performance than the trading fee. To make sure your trading plan is profitable, you must consider the impact of the market spread while putting it into practice.

Let’s use the Aave token and Coinbase bid/ask spread as an example. If Aave’s lowest Ask price in a Coinbase order book is $1,200 and the highest bid price is $1000, the coinbase spread here is $200. And using the calculation given in “how to calculate market spread”, the spread percentage is 16.67%.

If the spread does not change, any trader that places a buy order at the $1,200 price will have bought the AAVE at 16% premium compared to if he placed a limit order at $1000 and waited for a fill. 16% market move isn’t negligible.

If, for instance, AAVE is on a bullish run from $1200 to $1450, and the trader wants to take profit, he would pocket only $250 instead of $450.

In order to maximize gains, we must consider the spread when placing a trade. From a theoretical standpoint, it could seem to be far simpler to make money on an asset with a small spread than one with a wide spread because the directional move of the asset must be more significant when the asset was purchased more expensively due to wider spread.

However, the assets with wider spreads tend to be more volatile than the assets with tigh spread, hence higher price swings are to be expected.

Source: academy.shrimpy.io

Conclusion

As said earlier, in order to understand the cryptocurrency market, one must understand what crypto trading spread is. This knowledge guides the selection of exchanges, understanding of investment costs, and helps make more educated investment decisions.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.

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